An Empirical Study on Spillover Effects between CDS and FX at Korean Market

Janghee Lee

This paper has empirically investigated the shock and volatility spillover effects of counterparty risk on the deviations from CIP in the FX forward market of Korea. During the recent financial turmoil, there is significant shock and volatility transmission from the counterparty risk of European CDS market to the CIP deviations of FX market under investigation. In addition, the shock of counterparty risk for US corporations is more transmitted to the Korean FX market than that of the Korean Sovereign risk. FX Forward deviations tended to depend more on investment-grade European and US corporations rather than on Korean Sovereign ones, because the shock and volatility of the European and US CDS indexes were more transmitted to CIP deviations relative to those of Korean Sovereign. This finding is consistent with the view that the demand for dollar liquidity in the Korean FX market during the turmoil stemmed from mainly dollar Libor panel banks, such as European and US banks, rather than the financial institutions of emerging countries like Korea.